The term delta refers to the change in price of an underlying stock or exchange-traded fund (ETF) as compared to the corresponding change in the price of the option. Delta hedging strategies seek to reduce the directional risk of a position in stocks or options.
The most basic type of delta hedging involves an investor who buys or sells options, and then offsets the delta risk by buying or selling an equivalent amount of stock or ETF shares. Investors may want to offset their risk of move in the option or the underlying stock by using delta hedging strategies. More advanced option strategies seek to trade volatility through the use of delta neutral trading strategies.
Offsetting Delta Risk
Assume that SPY, the ETF that tracks the S&P 500 index, is trading at $205 a share. An investor buys a call option with a strike price of $208. Assume the delta strength for that call option is 0.4. Each option is the equivalent of 100 shares of the underlying stock or ETF. The investor can sell 40 shares of SPY to offset the delta of the call option. If the price of SPY goes down, the investor is protected by the sold shares. The investor has a delta neutral position that is not impacted by minor changes in the price of SPY.
The delta of the overall position shifts as the price of the underlying stock or ETF changes. If the investor wants to maintain the delta neutral position, he has to adjust the position on a regular basis. The disadvantage of doing this is the commissions and costs that eventually impact the profitability of the strategy.
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